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The Crisis That Made The Eurozone

03-03-2014Most economists have been too pessimistic about the Eurozone crisis. The famous names who forecast a Eurozone breakup – Martin Wolf, Niall Ferguson – were generally guilty of confusing “broken” with “cannot be fixed”.

There were good reasons for this confusion. Politicians in European countries engaged in repeated games of brinkmanship in an effort to obtain more attractive bailout packages. The winning strategy in brinkmanship is, of course, to convince the other side that one is willing to go over the brink, while disregarding the increasingly extreme threats from one’s negotiating partner.

To this end, politicians in bailout recipient countries make a lot of threats that they did not, in fact, intend to carry out – e.g., “we will leave the Eurozone if you do not offer a better bailout package”. AAA-rated countries made equally empty threats – e.g., “if you do not undertake reforms, we will not give you a bailout”. Economists tended to take these negotiating-strategy pronouncements at face value.

Moreover, a necessary measure of bargaining power in these games of brinkmanship was the impact on financial markets. German bank stocks would plummet when the Greeks threatened to leave. Interest rates on Greek debt would soar when the AAA-rated countries threatened to throw the Greeks out.

Economists are accustomed to interpreting market distress as a sign of economic distress. In this case, these market movements meant that both Northern Europe and Southern Europe had leverage, and the bailout packages were relatively equitable.

The last such attempt at brinkmanship (so far) was Cyprus, whose disingenuous claims to be on the verge of leaving the Eurozone produced almost no market reaction in Northern Europe. The bailout package that Cyprus received was therefore almost punitive in its terms.

And yet Cyprus did not leave the Eurozone. This development is perhaps almost as important as the promise of ECB support – Draghi’s “whatever it takes” promise – in giving us confidence that the acute phase of the Eurozone crisis is at an end. When Cyprus did not get the deal it wanted, and stayed in the Eurozone regardless, it demonstrated that the threats of deliberate Eurozone breakup were, in the end, empty threats, no more than a negotiating tactic. This will (thankfully) make it very hard for Eurozone politicians to make credible threats in future.

Economists also failed to grasp that the bitter political disagreements dividing Eurozone countries were disagreements not about whether the Eurozone should continue to exist, but about who should pay to fix it (Southern Europeans through austerity or Northern Europeans through bailouts). The answer, of course, is both. But the question of where one draws the line is a question worth billions of Euros, so it was, unfortunately, worth fighting over.

As an economist myself, it is difficult to be very optimistic about the near-term future of the Eurozone. While the US has already worked its way through much of the debt overhang that built up during the pre-crisis years, in most Eurozone economies, deleveraging has hardly begun. As citizens and companies squirrel away funds to pay debts, Europe will have difficulty returning to pre-crisis growth rates for years to come.

And at the same time, I wonder if economists might not once again be showing undue pessimism about Europe. In recent years the euro has failed to fulfil its potential largely because European Union institutional arrangements were poor. As is now well known, Europe had monetary union without fiscal union. It was difficult to have confidence in a currency that mixed competitive Northern economies with uncompetitive Southern economies.

As result of the Eurozone crisis, a banking union, fiscal union, and possibly even a unified debt are very much on the table. Far from breaking the euro, the crisis could enable the euro to at last realise its potential as a global reserve currency alongside the dollar. This would be tremendous boost in the long term. Having a currency used to denominate world trade will be a major advantage for a continent that is already, according to Oxford Economics forecasts, set to account for the largest share of global trade growth to 2020. For ageing and indebted European countries, the ability to borrow internationally in their own currency will be even more welcome.

One could even imagine the structural reforms now being put in place under duress in Southern Europe producing an entire continent with competitiveness to rival Germany and the US. Spain has already experienced a stunningly positive “competitiveness shock” (again, contradicting the predictions of most economists). Of course, with France and Italy too large to push to the brink, this may be a dream too far, even for an optimist such as myself. But it is worth remembering that up to now many economists have erred on the side of pessimism regarding Europe – and been proved wrong.

Source: The Outlook Blog from Sam Wilkin,

Sam Wilkin offers economic and political insight with humor, drama and an eye for ironic details, in the words of Belgium’s Trends magazine. Sam is also one of those rare economists able to deliver a positive, inspiring message – indeed, when most pundits were predicting disaster in the Eurozone, Sam was arguing, accurately, that the currency bloc would hold together. Backed by the unmatched resources of Oxford Economics (which produces forecasts for more than 190 countries, 100 industries and 2,600 cities globally), Sam delivers not stump speeches but messages matching the interests and concerns of the attendees of your event.

Sam is Head of Business Research at Oxford Economics, one of the world’s foremost global forecasting and research consultancies. Founded in 1981 as a joint venture with Oxford University’s Templeton College, Oxford Economics now has more than 70 economists on staff and provides forecasts for 190 countries, 100 industries, and 2,600 cities and regions globally.

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